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Saturday, June 11, 2011

An excellent visual of the size and composition of the sovereign debt bailouts (so far). Spain will be larger in size than these first 3 combined, and Italy currently has over $2 trillion of toxic debt pumped directly into the global banking system.

After that we move to Japan and the UK. If you can still purchase precious metals at any price during these two monster bail outs, it may be the last opportunity under the current monetary system. For more on that topic see Sovereign Debt: Global Evolution.

Friday, June 10, 2011

This post will push further than my normal scope of discussion, but it is important to look at the future of our global financial system as the world rapidly approaches the next major storm.

I often discuss how the coming global sovereign debt crisis will play out. Country by country over the next few years will follow the same scenario currently playing out in Greece today. It is the blueprint for the future. The following is the order I believe the crisis will strike as it moves throughout the world:

The speed in which the virus spreads depends on the policy response from governments and central banks.

The size of each nation's debt crisis is larger as you move down the list above. If any country decides not to bail out their government bond market with a flood of printed currency, there will be a banking collapse similar to what was seen back in 2008 during the subprime meltdown. Banks hold a tremendous amount of government bonds and if they were forced to write down the value of those bonds they would not have the capital cushion to keep their doors open. (The Lehman Brothers scenario)

This does not factor in the derivatives market; the hidden off balance sheet bets banks place. The term "CDS" or Credit Default Swap became a household name back in 2008 when investors found out banks like Goldman Sacs were hedging their real estate portfolio by taking out insurance on the bonds they purchased. (CDS contracts) AIG took on the lion share of these insurance claims. When real estate collapsed and the insurance was needed, AIG had no capital reserves to make the payments.

The size of the CDS derivatives market at the peak in 2008 totaled about $60 trillion. To put the magnitude of that size in perspective, the entire value of all global stock markets combined is less than $60 trillion today.

There is another form of derivatives insurance called an Interest Rate Swap. Banks, similar to the strategy used during the boom in real estate, use these contracts to protect themselves against sharp moves upward in interest rates; a move you would see when government bond yields rise sharply around the world.

The size of this Interest Rate Swap market?

Over $300 trillion.

It is important to note that in addition to Interest Rate Swaps, banks are also using Credit Default Swaps (CDS) to buy insurance against government debt default. The size of the total derivatives market is staggering. The coming collapse is fairly easy to see and understand, just as the real estate collapse was during 2007. What happens next is something that is rarely discussed.

At some point there will be a run away from paper government debt (and a continued run away from real estate debt) which will cause trillions of dollars to look for a home. I believe a large portion of this will end up in commodities with the biggest winners being gold and silver.

What most people do not realize is that during this process the United States as a country will benefit greatly. The following graph shows the top holders of gold for countries around the world:

When gold re-values itself (thousands of dollars higher) to reflect the fallen value of paper currencies, the United States' real wealth will rise in relation to the rest of the world. Does that make sense? Take a moment to let this extremely important concept sink in.

Ironically, we have spent the past 30 years taking the goods created by the sweat and labor of foreign countries and in exchange we have given them I.O.U.'s. Paper I.O.U.'s worth nothing but the believe that they will be able to purchase goods in the future.

When the world accounting process takes place, the United States will be left holding the largest share of gold and the largest military. We will have the first chair during the conversation to create a new currency system.

Americans holding precious metals (and commodities) during this accounting process will move to the top 1% of wealth in our nation. All other American's wealth will be revalued drastically lower to reflect the new currency valuation created.

This process could take a decade to unfold, but it is important to understand the entire picture as you make investment decisions on both the short and long term.

Neil Barofsky, who recently stepped down as the Special Inspector General for the $700 billion bank bailout in 2008, discusses what comes next:

A $5 trillion bank bailout. Understanding that nothing has changed between 2007 and today, other than the assets on bank balance sheets are now worth far less (real estate) and leverage is back at new all time highs (piling into the stock market), his only question?

This past weekend I was at a friend's birthday having a conversation with someone who works for a commercial construction company in Fayetteville, NC. He must travel 3.5 hours to work every week to his jobsite.

He has spent the last few weeks looking for work here in Charlotte but has had trouble landing a position. The reason is not his experience or knowledge, he has a tremendous amount of both, but that Charlotte is like most areas in the country where very little real estate construction is taking place.

What is so special about Fayetteville?

Government spending. 44,000 new military jobs are on the way to the small city creating a massive demand for all types of new infrastructure.

Yesterday I took my 8 hours of mandatory continuing education to get keep my real estate license active in North Carolina. While we spent the beginning of the class discussing how horrible the market conditions are today, the teacher stopped and asked if anyone knew what North Carolina city was just announced with tops in the country for greatest home price appreciation?

I raised my hand, "Fayetteville, NC?"

"Correct," he answered. "Right now they can't get enough new homes out of the ground."

Yesterday I discussed the importance of not only looking at the numbers of a real estate transaction, but the surrounding community the property will be located in. My Apartment Case Study was a community located in Fayetteville, NC. Does this information now change your view of asset? It should.

American military spending will be a dominant force in the global economy until our government reaches our Greek moment and is forced to cut spending. That moment may come next month, but it may not come for another 3 to 4 years. Until then, you must continue to respect and plan investments according to this incredible force of spending. The following graph shows where we rank against the rest of the world, combined.

Tuesday, June 7, 2011

I run simulations on commercial buildings around the country on a regular basis because I enjoy continuing to keep a pulse on the market. I came across a property for sale last week in a growing North Carolina city.

The property is a large apartment community with 2010 annual revenue of $2,880,258. The total annual expenses for the community (not included the cost to finance the property) were $1,235,685.

As a manager of commercial real estate, the only thing you are in control of is the Net Operating Income (NOI). Your goal is to increase revenue and decrease expenses. The NOI is the income an investor would bring in every year if they paid cash for the property.

The second component, used to determine the purchase price for a property, is what return on their money an investor needs to receive $1,644,573 every year.

This is determined based on the mood of the market, something a commercial manager has no control over. For example, the current asking price on this property is $26,000,000. This means the seller is hoping someone will purchase the property for only a 6.33% return. (cap rate)

To keep the analysis simple I will avoid a discussion on the debt owed on the property, currently around $20,000,000.

Is 6.33% a strong return for an apartment community?

The first component of this answer is determined by looking at the quality of the building, the employment base and growth in the area, and the potential to increase NOI through improved management.

The second component is where a 6.33% return stands against other investment opportunities. This asset, along with every other stock, bond, commodity, or piece of real estate around the world is competing to receive a portion of the total global capital available to invest.

If a real estate investor has the ability to combine both strong management (ability to increase NOI) and has a fluent understanding of this global financial marketplace they can become a lethal force.

I personally believe that 6.33% is not currently a strong enough return to take on the risk of ownership in a building. Why?

The global benchmark used to determine interest rates is the ten year US government treasury bond, which currently just fell below 3%. Most loans are determined based on the ten year treasury plus some sort of "spread" to determine the price banks or investors will lend.

It is my contention, a topic discussed thoroughly on this site, that the 10 year bond will rise dramatically over the next few years due to the United States' insolvency, inflation, and the fact that it is already extremely expensive based on historical standards.

When that time comes it will be a surprising blow to real estate investors who today are pricing in all time record low rates "forever." The patient investor must step back and understand that this dynamic cannot continue forever and that overpaying for an investment using a tremendous amount of debt is a deadly combination.

"We should be careful to get out of an experience only the wisdom that is in it and stop there lest we be like the cat that sits down on a hot stove lid. She will never sit down on a hot stove lid again and but she will never sit down on a cold one either."

- Mark Twain

"It's waiting that helps you as an investor, and a lot of people just can't stand to wait."

- Charlie Munger

"Live as if you were to die tomorrow. Learn as if you were to live forever."

- Gandhi

"One of the best rules anybody can learn about investing is to do nothing, absolutely nothing, unless there is something to do. I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up. I wait for a situation that is like the proverbial shooting fish in a barrel."

- Jim Rogers

"Capitalism without financial failure is not capitalism at all, but a kind of socialism for the rich."

- James Grant

"At this juncture, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained."

- Ben Bernanke, March 2007

"Everything that needs to be said has already been said. But since no one was listening, everything must be said again."

- Andre Gide

"When people are getting richer and richer but they're not actually producing anything, it can't end well."

- Louis CK

"In economics things take longer to happen than you think they will, and then they happen faster than you thought they could."

- Rudiger Dornbusch

"I don't write about what I know. I write to find out what I know."

- Patricia Hampl

"Chains of habit are too light to be felt until they are too heavy to be broken."

- Warren Buffett

"Everyone has a plan until they get punched in the mouth."

- Mike Tyson

"Interest on the debt grows without rain."

- Yiddish Proverb

"You can have comfort, or you can have value. You cannot have both."

- Jim Grant

"Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."

- Warren Buffett

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."

- Ludwig von Mises

"Men who can both be right and sit tight are uncommon."

- Jesse Livermore

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

-Ludwig von Mises

"Most investors think quality, as opposed to price, is the determinant of whether something's risky. But high quality assets can be risky, and low quality assets can be safe. It's just a matter of the price paid for them."

- Howard Marks

"Whenever you find yourself on the side of the majority, it is time to pause and reflect."

-Mark Twain

"None are more hopelessly enslaved than those that falsely believe they are free."

-Goethe

"The longer the markets disobey basic rules of valuation, the bigger the opportunity for good investors to reap the benefits. Value investing works precisely because markets become dysfunctional at times."

-John Coumarianos

Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

-Sir John Templeton

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."

- Ludwig von Mises

"People only accept change in necessity and see necessity only in crisis."

-Jean Monnet

Requiring a central bank to print money to increase government's purchasing power invariably ignites a hyperinflationary firestorm. The result through history has been toppled governments and severe threats to societal stability.

- Alan Greenspan

"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."

- Henry Ford

"Do you want to sell sugared water for the rest of your life? Or do you want to come with me and change the world?"

-Steve Jobs

"I'd be a bum on the street with a tin cup if the markets were always efficient."

-Warren Buffett

"The market can stay irrational longer than the investor can stay solvent."

- Keynes

"While the government struggles to save one crumbling enterprise at the expense of the crumbling of another, it accelerates the process of juggling debts, switching losses, piling loans on loans, mortgaging the future and the future's future. As things grow worse, the government protects itself not by contracting this process, but by expanding it."

-Ayn Rand, 1974

"The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function."

- F. Scott Fitzgerald

"All our life, so far as it has definite form, is but a mass of habits - practical, emotional, and intellectual - systemically organized for our weal or woe, and bearing us irresistibly toward our destiny, whatever the latter may be."

-William James

"Men it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

-Charles Mackay

The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge.

- Stephen Hawkings

"Give me control of a nations money supply, and I care not who makes it's laws."

- Amschel Rothchild

Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.

- Sigmund Freud

Many of life's failures are people who did not realize how close they were to success when they gave up.